A credit score is among the most objective tools used by banks to ascertain a customer’s credit risk.
“Quick to borrow is always slow to repay”.
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Borrowing and lending money are among the oldest economic activities on Earth. And equally old is the question of whom to lend to. That’s really the business that banks are into; they take deposits, give loans, charge a certain rate of interest and manage risk, such that they are able to lend profitably.
Now, various tools are used by banks to differentiate between customers who could have different credit risk profiles. The credit score is among the most objective tools used by banks to this end. This three-digit number ranging from 300-900 is used by banks to predict the probability that a customer will default on the loan.
The lower the score, the higher the chances of default implying a high risk. Banks, therefore, charge higher rates to customers with low credit scores, assuming they even lend to them in the first place!
Credit scores have over a 100-year history in developed economies. In India, this concept is much more nascent and indeed, the Credit Information Act is just over a decade old. A natural corollary has been a limited awareness of the concept of credit scores among Indians. This three-digit expression of one’s credit profile potentially can have a six-digit impact on the financial aspect of one’s life.
This three-digit credit score is indicative of the probability of an individual defaulting over a certain period of time. Ranging from 300 to 900, a higher score depicts a lower probability of default. A score of 750 and above is deemed to be a good score. In case of a lower score, the individual can get denied or can be extended the credit facility at terms that are quite harsh. And one of the terms could be charging a higher rate of interest. An increased rate will have a severe impact on the finances.
Mr A and Mr B applied for a home loan of Rs 1 crore and were granted. However, while Mr A was charged a rate of 10 percent, Mr B was offered the same loan at 8.75 percent. This difference of 125 basis points (1 percentage points is 100 basis points) will have gross financial implications. Mr A will end up repaying a higher amount of 19.51 lakh rupees as interest in comparison to Mr B. It pays to have a good credit score!
Today, people take loans for various purposes. For the various needs in life including buying a house, cars, funding needed for a child’s education or marriage; a loan is invariably the answer. Even smaller gadgets today get purchased on instalments. The impact that an increased EMI on all the loans that one would take at various stage in life, on account of low credit scores and consequent high-interest rates getting charged, could well turn out to be a small fortune.
A higher EMI while, on one hand, would make the credit more expensive, on the other hand, it will also be impacting surplus money available for investing. It means that the higher interest is leading to eroding the corpus building and wealth creation. A double whammy!
As we observe the three-digit scoring will impact one’s finances in six digits either positively or negatively, depending upon the score that one gets assigned. A good score will aid one’s financial objectives.
Another important point to ponder upon is that in today’s life credit has become an integral part. A poor credit score can even lead to a situation where the access to credit is constrained. This can result in losses or a highly stressful situation in case of a personal exigency.
Apart from the world of loans, credit scores are beginning to be used in various other walks of life including telecom, insurance, job applications, visa applications, board directorships and tenancy checks among others.
Over time, the data and reach of the credit scoring methodology are poised to increase exponentially. It goes without saying that one is required to manage and maintain the credit profile if one is serious towards their financial goals.
Arun Ramamurthy is the founder and director of Credit Sudhaar, a credit advisory services company.
First Published: IST